Fiscal and Monetary Policy

Imagine you are listening to the radio around the year 1900 and there is news that the economy is going to enter into a recession. Chances are that sooner or later you will not have a job, and there isn’t going to be nearly as many goods available because of lack of production. The only thing of any value will end up being the money in your checking and savings accounts, so the only choice you have it to run to the bank and get hold of that money. The problem: every other person who just heard that announcement is thinking the same thing, and now there’s going to be a run on the bank, or even worse, a bank panic. This was a serious dilemma prior to the year of 1913 – the year the Federal Reserve Bank was established – because there was no way to ensure the economy would remain stable. Although bank panics were not an everyday thing, it was something that citizens had to worry about more than they do today. When the Federal Reserve Act of 1913 was set in place, however, two policies were enabled to monitor and help control the stability of the economy: to this day they remain a very important part of our government and these courses of action are known as monetary policy and fiscal policy.

To fully understand the purpose of monetary and fiscal policy, it is important to look at the structure behind them. The basis of these policies comes from the Federal Reserve. The “Fed” is a fairly simple system to understand: it is the central bank of the United States. This central bank is broken down into districts; the Board of Governors being the most recognized, but also included is the Federal Open Market Committee. Today the head chairman of the Board of Governors is Benjamin Bernanke, and he oversees all the actions that are taken.

The Federal Reserve is the only bank with the power to control a run on the banks or a bank panic. It holds the money available to lend to smaller banks as a last resort in bad economic times. Therefore, the Federal Reserve plays a huge part in controlling the money supply of the US. When the “Fed” was established, so was monetary policy. In the book Macroeconomics by R. Glenn Hubbard and Anthony Patrick O’Brien, monetary policy is defined as “the actions the Federal Reserve takes to manage the money supply and interest rates to pursue economic objectives.” These certain objectives include maintaining a stable economy, increasing economic growth, keeping unemployment at a satisfactory low, and keeping prices of goods and services stable in order to minimize the chances of inflation.

The Federal Reserve uses three separate tools of monetary policy to maintain the money supply. These tools include open market operations – controlled by the Federal Open Market Committee – and the discount rate and reserve requirements, which are controlled by the Board of Governors. Open market operations are a tool used by the FOMC to increase the money supply through the buying and selling of Treasury securities. The trading desk at the Federal Reserve Bank in New York is designated to buy these securities and the sellers deposit them into banks. These deposits increase the reserve of the bank which in turn increases the total money supply because there will also be an increase in loans and checking account deposits (Hubbard/O’Brien). The FOMC also has the power to decrease the money supply by reversing the operations of that same process.

The branch of the “Fed” which controls the other two tools of monetary policy is the Board of Governors. One tool, the discount rate, is defined as “the interest rate the Federal Reserve charges on discount loans (Hubbard/O’Brien). If a bank needs to increase the money available in their vault, otherwise known as their reserve, they turn to the “Fed” for the money and this loan is known as a discount loan. However, unless the Federal Reserve has become the last resort in the case of a recession, discount loans are not typically taken out by banks.

In certain instances, such as the case of Black Tuesday when the worst stock market crash hit the United States, discount loans did not save the economy. It was not until after the Great Depression when the run on the banks caused a severe bank panic that Congress established deposit insurance. In other words, prior to the Federal Deposit Insurance Corporation, a person was neither assured that the money they held in the bank was safe nor that they would be able to retrieve it if the economy were to fall into a recession.

The third tool of monetary policy which is also controlled by the Board of Governors to help manage the money supply is reserve requirements. It is a rare occasion for the Fed to change the reserve requirements though. In essence, changing the reserve requirements entails the banks to make “significant alterations in holdings of loans and securities” (Hubbard/O’Brien). Although it is not a common course of action, it is still purposeful. When the Fed decreases the reserve requirements, it allows the banks to use the excess money to loan out as opposed to holding in the vault. Conversely, if the Fed chooses to increase the reserve requirement, the banks will have less money to lend out. Either way, though, the Fed is makes the change based on the assumption that it will help the economy. All of these tools of monetary policy are followed through with the intention of meeting the objectives stated previously. On the other hand, fiscal policy also plays and important role in helping to maintain a stable economy.

Fiscal policy is defined as “the changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives” (Hubbard/O’Brien). Fiscal policy is similar to monetary policy in terms of what it attempts to achieve, but varies because of the way it tries to do so. Changes in taxes and spending are controlled solely through the federal government.

A better understanding of fiscal policy can be explained through the ideas of John Maynard Keynes. His theory came about after the Great Depression and said if the governments were to spend more money in times of economic decline, then it would soon stimulate the economy. He argued that through the excessive government spending, incomes would rise and so would purchases of goods and services. Eventually, this would stabilize the economy and take the country out of decline and into a state of economic growth. His theory was proved when President Franklin D. Roosevelt took action during World War II and spent an excessive amount of money which ending up in economic growth, as Keynes had said it would (What is Fiscal Policy?).

More recently, as of the 1980s, the main goal of fiscal policy has focused on reducing the budget deficit that has skyrocketed since World War II. Because of such things as new technology and foreign trade opportunities economic growth has been happening automatically, and the deficit only continues to rise (What is Fiscal Policy?). The War in Iraq has also caused the deficit to steadily increase, and George W. Bush is currently under pressure to find a way to decrease it. Although the overall goal of fiscal policy is to achieve broad goals of the economy, it now focuses on smaller goals as well.